Global Market Outlook: battling the bond blues

Stocks: off to a strong start

Global equities posted further gains in January, with the MSCI All-Country Index returning 4.1% in local currency terms. By contrast, Australia’s S&P/ASX 200 Index delivered a negative 0.4% return, and continued the general trend of underperformance that has been evident over the past year. The trend for global equities remains firmly up, though the pace of gains in recent months has been so strong that a “cleansing pull back” seems overdue.

There were few negative shocks for the market to contend with over the past month, with economic data in most corners of the world continuing to strike an upbeat tone. The passage of US tax cuts in late 2017 also continued to underpin market sentiment and has already led to some upgrades to 2018 US earnings expectations.

That said, the lift in US average hourly earnings in the January payrolls report caused bond yields to spike higher and led to a notable drop in US equity prices late last week.

US wages: time to worry?

How worried should we be about the rise in US wages? As evident in the chart below, although annual growth in US average earnings hit 2.9% in January (widely reported as the “highest rate since June 2009”), it’s probably fairer to say wage growth has been moving broadly sideways in a choppy range (averaging around 2.75%) for some time. Last year’s cyclones added to the volatility in average earnings by disrupting the usual seasonal hiring of (lower paid) hospitality workers. January’s result was also pushed up by a raft of one-off minimum wage increases in a number of States.

As it turned out, the 0.3% monthly gain in average earnings was in line with market expectations, but upward revisions (due to annual seasonal re-analysis) to wages in earlier months produced a higher than expected 2.9% annual rate of growth. Note each time annual wage inflation has spiked close to this level in recent years it has tended to drop back down again – and my expectation is that it will ease back down again in coming months due to the ongoing competitive price pressures still faced by corporate America.

That said, unless another wrenching global credit crisis intervenes first, an eventual lift in US wage and price inflation – as the economy continues to push upon capacity constraints – remains the most likely culprit to eventually kill the current bull market, but I still suspect this is at least a year away.

Fundamentals still supportive of global stocks

Indeed, turning to the fundamental drivers of global equities, it’s evident that both forward earnings and rising valuations (the price-to-forward earnings ratio) have helped push prices higher over the past year.

As regard earnings, the outlook remains positive, with earnings expectations for both FY’19 and FY’20 consistent with growth in forward earnings of around 10% over the next 12 months. Note, moreover, earnings expectations have tended to be revised up in recent months.

As regard valuations, further upward pressure on bond yields seems likely to check the recent trend higher in the PE ratio – which is already at above average levels. That said, at around 4.3%, the equity-to-bond yield differential has only recently just reached its longer-run average (i.e since 2003) and remains somewhat above the pre-GFC average (2003 to mid-2007) of 3.2%. That suggests there remains some scope for this differential to narrow further, thereby limiting the downward pressure on the PE ratio.

All up, I remain positive on the year-ahead outlook for equities, with rising earnings more than offsetting a drag caused by falling PE ratio – as I expect the rise in interest rates to remain modest and some of the adjustment to higher rates to come from a further narrowing in the equity-bond-yield differential.

Sector/Regional Themes: Technology, Resources and Japan

Among our key sector and regional exchange traded funds, our Global Banks ETF (BNKS) produced the best return of 6.5% in January, while our NASDAQ-100 ETF (NDQ) returned 5.4% – which is especially impressive considering NDQ is unhedged and the $A also appreciated 3% in the month.

Based on a momentum ranking (an average of three and six-month return performance),the top-ranked performers at end-January were NDQ, our Australian Resources Sector ETF (QRE) and our Japanese Equities ETF (Currency Hedged) (HJPN). NDQ’s strong performance is consistent with global technology remaining an important lead sector in the current bull market. QRE has performed especially strongly over the more recent six month period reflecting commodity price optimism, given synchronised global growth. Japanese equities have also continued to post good gains due to the improving Japanese economic outlook, relatively good valuations by global standards, and solid gains in corporate earnings. BNKS is also benefiting from rising global interest rates as this tends to boost the profitability of financial companies.

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